New products and services: Analysis of regulation shaping new markets

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Karlsruhe, February 2004

Study funded by the European Commission

DG Enterprise/Innovation Policy Unit, in the framework of

the Innovation /SMEs programme, part of the Fifth Research

Framework Programme.

New products and services:Analysis of regulations shaping new markets

Final report

Karlsruhe, February 2004

Directorate-General for Enterprise

EUR 21321

41AO25_pag_lim_p1 16-11-2004 13:47 Pagina 1


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Foreword

The Fraunhofer Institute for Systems and Innovation Research produced this reporton behalf of the Innovation Policy Unit of DG Enterprise in the European Commis-

sion in the framework of the Innovation /SMEs programme, which was part of the

Fifth Research Framework Programme.

A project team led by Dr Knut Blind produced this report. Dr Bernhard Bhrlen

was responsible for the case study in the pharmaceutical sector. Professor Klaus

Menrad produced the case study in the food sector. Both supported also other tasks

of the project together with Sabine Hafner. The case study on environmental tech-

nologies was produced by Dr Rainer Walz and Christiane Kotz. I would also like to

thank the companies and the other organisations who responded to the survey orwere willing to spend some time being interviewed.

A multi-national expert panel supported the work of the team, and I would like to

thank Karin Basenach, Poul Erik Grohnheit, Beate Kettlitz, Dr Veit Ghiladi, Domi-

nique Taeymans, and Professor W. Bruce Traill, for their effective contributions

in attending two workshops, by telephone and in person.

Finally, I would like to thank Jos Ramon Tiscar and Aisling Quirke as members of

the Innovation Policy Unit, who provided many useful strategic, tactical and ad-

ministrative insights.

However, responsibility for the final report remains with the Fraunhofer Institute for

Systems and Innovation Research.

Knut Blind

Fraunhofer ISI

February 2004


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Contents

Summary ................................................................................................................XI

1. Introduction .......................................................................................................1

2. A Conceptual Framework to Analyse the Relationship Between

Innovation and Regulation ...............................................................................3

2.1 Introduction ......................................................................................3

2.2 Types of Regulation..........................................................................4

2.3 The Assessment of the Impact of Regulation on

Innovation.........................................................................................7

2.4 Summary.........................................................................................14

3. Regulatory Systems Shaping New Markets ..................................................17

3.1 Introduction ....................................................................................17

3.2 A Taxonomy of Product Market Regulations.................................17

3.3 European Regulatory Reforms Shaping New Markets...................23

3.4 Regulatory Reforms in the Member States: The Case of

Network Industries ......................................................................... 40

3.5 Regulatory Reforms and their Impacts on Innovation in the

United States, Canada and Japan....................................................50

3.6 Concerns and Priorities of the Major European, USA andJapanese Regulatory Institutions ....................................................54

3.7 Comparative Summary ................................................................... 76

4. European Survey on the Role of Regulation for Innovation among

Different Stakeholders ....................................................................................79

4.1 Introduction ....................................................................................79

4.2 Empirical Results of the Company Survey..................................... 80


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4.3 Empirical Results of the Survey Among Research

Institutes........................................................................................102

4.4 Views of other Stakeholders......................................................... 112

4.5 Comparative Summary ................................................................. 134

5. Selected Case Studies on the Impact of Regulations on Innovation.........137

5.1 Introduction ..................................................................................137

5.2 The Impact of Regulation on the Development of New

Products in the Pharmaceutical Sector .........................................137

5.3 The Impact of Regulation on the Development of NewProducts in the Food Industry.......................................................150

5.4 The Impact of Regulation on the Development of New

Technologies in the Environmental Sector...................................165

5.5 The Role of Standards for Shaping New Markets........................184

5.6 Comparative Summary ................................................................. 201

6. Future Challenges for Regulatory Policy Shaping New Markets.............203

6.1 Introduction ..................................................................................203

6.2 The General Role of Innovation for Regulatory Policy ...............203

6.3 Approaches to Increase the Quality of the Regulatory

Framework regarding Innovation .................................................204

6.4 Coordination of Policies of Regulatory Bodies to Foster

Innovation.....................................................................................207

6.5 Improved Implementation of Regulations to Foster

Innovation.....................................................................................208

References..............................................................................................................211

Annex ....................................................................................................................217


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List of Tables

Table 1: Types of regulations and their impacts on innovation ...................... II

Table 2.4-1: Typology of regulations ...................................................................15

Table 2.4-2: Types of regulations and their impacts on innovation.....................16

Table 3.4-1: Policy Measures in Network Industries in 2001..............................41

Table 3.5-1: Most important sectoral economic regulation in the United

States, Canada, and Japan ................................................................52

Table 3.5-2: Impacts of the reform of sectoral economic regulation on

innovation in the United States, Canada and Japan ......................... 53

Table 3.6-1: Overview of Bodies responsible for Regulation in Europe,

the US and Japan..............................................................................55Table 3.6-2: Overview of Main Objectives to protect by Bodies

responsible for Regulation in Europe, the USA and Japan..............75

Table 5.2-1: Number of projects in clinical trial per 10 million

inhabitants ......................................................................................146

Table 5.2-2: Development and status of orphan designation procedures

in the EU .......................................................................................147

Table 5.3-1: Key figures of the EU food industry..............................................150

Table 5.3-2: Key figures of the US, Canadian and Japanese foodindustry in 1999 .............................................................................151

Table 5.3-3: Structure of the food industry by Member States in 2000 ............. 152

Table 5.3-4: Production of different branches of the EU food industry ............153

Table 5.3-5: Cancelling of R&D projects related to GMOs in the last

four years........................................................................................156

Table 5.3-6: Organic products in % of the produced volume of selected

agricultural products in the EU in 2000.........................................163

Table 5.4-1: Survey of the US environmental economy in 1993 .......................169

Table 5.4-2: Patent specialisation in partitions of environmental

technologies ...................................................................................171

Table 5.4-3: Instruments used in EU countries to foster wind energy ...............178

Table 5.4-4 Annual installations of wind turbines in MW in different

countries.........................................................................................181

Table 5.5-1: General Effects of Standards..........................................................186

Table 5.5-2: General Effects of Standards for New Markets .............................198


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List of Figures

Figure 1: Taxonomy of Product Market Regulations .....................................IV

Figure 3.2-1: OECD taxonomy of product market regulations .............................19

Figure 3.2-2: Taxonomy of Product Market Regulations .....................................22

Figure 3.3-1: Entry Regulations (Numbers and Days needed) in the

Member States, Canada, the United States and Japan ..................... 33

Box 3.4-1: Maintaining Universal Service Obligations (USO) ......................... 43

Figure 4.2-1: Importance of objectives to innovate ..............................................83

Figure 4.2-2: Importance of regulations as objectives to innovate

differentiated by sector.....................................................................84Figure 4.2-3: Factors hampering innovations .......................................................85

Figure 4.2-4: Importance of factors hampering innovation in the German

manufacturing sector........................................................................86

Figure 4.2-5: Factors hampering innovations differentiated by sector ................. 87

Figure 4.2-6: Importance of regulations relevant for new products and

services ............................................................................................89

Figure 4.2-7: Importance of selected regulations relevant for new

products and services differentiated by sector ................................90

Figure 4.2-8: Impacts of the regulatory framework relevant for the

introduction of new products and services.......................................91

Figure 4.2-9: Total impact of the regulatory framework relevant for the

introduction of new products and services ......................................93

Figure 4.2-10: Do regulations make it easier or more difficult for

companies to achieve determinants of successful

innovation?.......................................................................................94

Figure 4.2-11: Companies agreeing that regulations have triggered

innovations.......................................................................................95

Figure 4.2-12: Assessment of the current regulatory framework ............................97

Figure 4.2-13: Assessment of the future regulation system ....................................99

Figure 4.2-14: Importance of framework conditions for the initial

introduction of new products and services world-wide .................101


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Figure 4.2-15: Countries or regions with the most attractive framework

conditions for the initial introduction of new products and

services world-wide .......................................................................102

Figure 4.3-1: Factors hampering R&D in research institutes andinnovation in companies ................................................................104

Figure 4.3-2: Impacts of the regulatory framework relevant for R&D in

research institutes and the introduction of new products and

services...........................................................................................106

Figure 4.3-3: Assessment of the current regulatory framework .......................... 109

Figure 4.3-4: Assessment of the future regulation system...................................111

Figure 5.2-1: Pharmaceutical R&D expenditure in Europe, USA and

Japan 1990-2000 ............................................................................139

Figure 5.2-2: Breakdown of the world pharmaceutical market 1990-2000.........140

Figure 5.2-3: Estimated full cost of bringing a new chemical or biological

entity to market ..............................................................................143

Figure 5.2-4: Number of new chemical or biological entities (1987-2001) ........144

Figure 5.3-1: Reasons for cancelling R&D projects related to GMOs................ 157

Figure 5.3-2: Total number of field trials with GM plants in USA.....................158

Figure 5.3-3: Market development of different groups of Functional Food

in the USA......................................................................................160

Figure 5.3-4: Number of organic and conventional farms in the EU 1990

to 2001............................................................................................162

Figure 5.4-1: Market shares of European environmental protection

market in 1994 ...............................................................................167

Figure 5.4-2: The most important segments in the European

environmental protection market ..................................................168

Figure 5.4-3: Patent specialisation of environmental technologies in

selected countries ...........................................................................170

Figure 5.4-4: World trade shares of environmental technology suppliers

from 1989 to 2000..........................................................................172

Figure 5.4-5: Relative Trade Share (RTS) of selected OECD countries in

potential environment protection commodities, 1991 to

2000................................................................................................173


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Figure 5.4-6: Important actors in the interface of regulation and

innovation for wind power.............................................................177

Figure 5.4-7: Shares of installed wind capacity in 2002......................................180

Figure 5.4-8: Market shares of the suppliers of wind turbines world-wide

in 2001............................................................................................181

Figure 5.4-9: Projections of installed wind power for different countries...........182


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Executive Summary

Introduction

New products and services are the driving force ofa dynamic and prosperous

economy. Besides the direct public promotion of new products and services, e.g. by

public funding for research and innovation activities, framework conditions are cru-

cial for the success of new products and services in the market. In contrast to direct

support measures, we focus in this report on regulations shaping new markets as

indirect, but crucial framework conditions, which have often far reaching and am-

bivalent impacts and are therefore an important topic for policy makers, e.g. as dis-

cussed at the World Economic Forum 2004 in Davos. The study "New Products

and Services. Analysis of Regulations Shaping New Markets" aims to to reducethe lack of adequate, reliable and systematic knowledge on the relation between

regulation, including deregulation, on the one hand and the emergence of new mar-

kets on the other. On that basis, we aim to develop suggestions for a regulatory

frameworkwhich allows the emergence of new markets, and even to use regula-

tion systematically as an instrument to foster innovation.

The final report contains six parts. After the introduction, a conceptual framework

of the various relationships between regulation and innovation is presented by ana-

lysing the various, often ambivalent impacts of these regulations on innovation.

Then, we present an overview of regulatory systems shaping new markets, includ-ing a new taxonomy of product market regulations. Fourth, the views of

stakeholders, especially companies, on the impact of the regulatory framework on

innovation are presented. Fifth, the main results of three in-depth case studies cov-

ering the pharmaceutical, the food and the environmental sector are outlined. In

addition, examples ofstandards responsible for the development of new markets

are presented. We conclude with an outlook of future regulatory policies taking

the innovation dimension explicitly into account.

A Conceptual Framework to Analyse the Relationship between

Innovation and Regulation

The complexity of the relationship between regulation and innovation calls for

the development of an adequate analytical framework, which takes into account

the different aspects of the regulatory framework and the characteristics of the vari-

ous sectors.

The term "regulation" generally refers to the implementation of rules by public

authorities and governmental bodies to influence the behaviour of private actors

in the economy. Such intervention in the market is justified by the goal to maximise


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collective welfare, including reaching some distributive goals. In general, three

types of regulatory interventions are usually distinguished: economic, social and

administrative regulations.

Table 1: Types of regulations and their impacts on innovation

Type of Regulation Positive Impact on Innovation Negative Impact on Innovation

Economic regulation

Antitrust or pro-competition regulation

eases and enforces innovation prohibits (R&D) alliances

Protection of infantindustries (R&D subsi-dies, barriers to entry)

allows costly and riskyinnovations

continued protection does notenforce innovative activities

Public utilities:rate of return regulations;pricing at marginal costs

rents available for R&D andinnovation little and biased incentives to in-novate

Public utilities:price cap

incentives to reach productivitygains

-

Public utilities:competition

- price pressure and low profits donot allow to invest in innovation

Protection of selectedindustries (e.g. aerospace)

funds available for large R&Dprojects and innovation

no competitive pressure to inno-vate

Social regulation

Environmental regulations create incentives for new proc-

esses creating less environmentaldamage and for the developmentof new products

restrict innovative activities and

hamper the competitiveness andtherefore their innovative capacityregarding end-of-pipe technologies

Safety regulations increase acceptance of newproducts among consumers

additional restrictions forinnovators

Public goods provide infrastructure for innovative activities

reduced private sources forinnovative activities

Administrative regulation

Product liability producer liability increases theacceptance of new productsamong early adopters

too high liability reduces theincentive for producers ofinnovative goods

Intellectual propertyrights additional incentives to innovate additional protection for mono-polies hinders the diffusion of newtechnologies and products

The impact of regulation on innovation is difficult to assess, because innovation is

intrinsically a complex dynamic process with often contradictory aspects. In this

study we focus mainly on product innovations, following the OECD definition of

the "Oslo Manual", covering both goods and services introduced to the market

which are either new or significantly improved with respect to fundmental charac-

teristics. Table 1 summarises the potential impacts of regulation on innovation

following the regulation typology presented above.


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Regulatory Systems Shaping New Markets

For a more detailed and comprehensive analysis of regulations shaping new mar-

kets, the following new taxonomy of product market regulations was developedby screening the directory of the relevant Community legislation and clustering the

regulations and directives. The taxonomy is based on the assumption that regula-

tions concern actors or relations between actors and defines the following types of

relations (Figure 1):

Supplier-customer relationships External relationships of suppliers Interactions among organisations on the supply side.The main objective of regulating the supplier-customer relationship is to inform

and protect the consumer. The second type of relationship is the one between thesupplier of goods and services and external factors, which also include the work

force besides the environmental resources. All these regulations aim again to re-

duce negative externalities, e.g. to protect the environment by environmental

regulations, e.g. taxes on fossil fuels. Besides the regulation of the relations to cus-

tomers and the environment, the actors on the supply side need to be regulated in

order to prevent negative impacts for the consumers and society, such as these

caused by cartels.

Based on this taxonomy, we produced an overview of European regulations rele-

vant for the introduction of new products and services according to the categoriesdeveloped above. The overview of regulations with an impact on innovation based

on the new taxonomy of product market regulations showed the variety ofdifferent

types of regulation and the range of possible impacts on the introduction of new

products and services. The main results are the following:

often the impact of product market regulations on innovation is ambivalent one type of regulations, like labelling requirements, are soft framework condi-

tions for the introduction of new products and services

some regulations give companies strong incentives to develop and market newproducts and services, like:- direct financial support for the transfer from traditional to organic farming

- indirect financial incentives like the guarantee to have restricted competition

(e.g. orphan drug regulation for pharmaceuticals or fixed feed-in tariffs for re-

newable energies)

the liberalisation of several network industries on its own was a meta-deregulation allowing the market entry of new companies offering new and

often improved products and services.


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Figure 1: Taxonomy of Product Market Regulations (Source: own taxonomy)

Regulation of supplier-

customer relationship

Regulation of external

relationships of suppliers

Information and protection of

consumerProtection of external factors

Regulation of

entrepreneurship

and market entr

Regulati

operative

Labelling (e.g. food, drugs) Eco-labelling

Freedom and rules

of estabishing newcompanies

Regulation of product use (e.g.product safety, product

liability, privacy protection)

Legal certainty (e.g. electronic

signatures)

Market entry (and

exit) regulation

(e.g. licences,

contingents,

ownership barriers

for foreigners)

Regulation of interactions among

Product market regulation

Regula

cartels (trust la

cooperat

researc

vent

Merge

acquisitioRegulation of safety of the

work force

Liability for damages to theexternal factors

Product approval procedures

Regulation of inputs (e.g.

agrochemicals)

Regulation of production (incl.

notifications and certifications

of suppliersTaxes (e.g. fossile fuels) and

subsidies (e.g. renewable

resources)

Environmental regulations

(e.g.emissions, waste and

recycling requirements)

IPR (e.g. patents, copyrights, data

XIV


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Following the overview of European regulations, the corresponding review of re-

cent national regulatory reforms and its impacts revealed that within the so-called

network industries the most dramatic changes have taken place also due to the

deregulation initiatives of the European Commission:

We find an impact on innovation in the telecommunication sectors by the en-try of new companies into these markets offering a broad range ofnew prod-

ucts and services also supported by the development of new technologies

In the energy sector, the liberalisation of the markets is at the very beginningand the market entry is still difficult, therefore the entry of new companies and

the supply of new products and services is still restricted

Within the postalservices the incumbents still dominate the market and com-petition in new products and services is primarily takingplace in certain niches

In air transport the traditional European flag carrierscame under great pres-sure from low cost carriers which leads more to cost-saving procedures and

less to new products and services

There is still dissatisfaction with railway services and the experience with lib-eralisation is mixed due to frequent accidents in the liberalised markets.

The review of recent regulatory reforms in the USA, Canada and Japan showed

that the USA especially has reduced all regulatory restrictions in some sectors,

whereas Japan is still at the beginning of deregulation in some sectors. In general,

regulatory changes leading to a stronger competitive pressure have a positive im-

pact on the prices and quality of products and services, but also on the introductionof innovative products and services.

Although innovation is a rather important impact dimension of regulation from a

normative perspective (see Table 1), its factual appearance within regulations is

rather limited. Therefore, we analysed in-depth the objectives and missions of in-

stitutions and bodies responsible for regulatory policies in the European Union,

the USA and Japan. This screening revealed the following priorities:

The promotion of innovation is only an explicit goal for the bodies which areresponsible forcompetition issues

In regulatory bodies responsible for very dynamic sectors, like telecommunica-tion, we find the promotion ofinnovation as a further objective

Most regulatory bodies have conservation- or protection-oriented missions,like those responsible forenergy, the environment orhealth and safety

The regulatory bodies in the USA are more likely to have the promotion ofin-novation on theiragenda compared to Europe, but definitely more in relation to

the Japanese bodies.


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European Survey on the Role of Regulation for Innovation among

Different Stakeholders

This section presents results of surveys on the role of regulation for innovationamong stakeholders. First, the results of a company survey are presented, based on

the answers of a random sample of more than 250 mostly European companies

mainly active in six sectors (environmental sector, food sector, pharmaceutical

sector, mechanical engineering, electro-technology, transport and telecommunica-

tion services).

The following main results can be reported from the perspective of the companies:

regulations have both positive (e.g. for the quality) and negative impacts (e.g.for the time to market) on aspects related to the introduction of new productsand services

the most positive impacts of the regulatory framework for companies intro-ducing new products and services are

- the protection from liability claims- the increase ofacceptance of new productsby consumers and users- the enhancement of the quality of products and services

regulations have especially strong negative impacts on- labourcosts- energy and material costs- costs for the development and the introduction of new products and services

fulfilling governmental or non-governmental regulations is among the set ofobjectives (e.g. expansion of market share) for companies to perform innova-

tion activities only ofsecond priority

in relation to other obstacles, the implementation of governmental regulationsis a serious obstacle for the introduction of new products and services

non-governmental regulations, e.g. standards, are less restrictive for innova-tion

health and safety aspects, the quality of products and services, and the questionof liability are the most important regulations for the introduction of new

products and services it has to be noted that

- specific types of regulation create market opportunities for new products- regulations in general do not make the development and market introduction

ofnew products and services impossible

regarding the assessment of specific regulatory issues, we find that a large con-sensus among companies exists that

- approvalprocedures are both too costly and too long- public help regarding the fulfilment of regulations is not sufficient- the number of regulations is perceived to be definitely too high- the implementation of regulations is often not flexible and transparent


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due to the obvious dissatisfaction the companies require that- regulations have to be regularly adjusted to the state-of-the-art in science

and technology

-each new regulation should undergo an impact assessment, which also takesinto account the market introduction of new products and services

- policies of different regulation bodies should be better co-ordinated- companies should have to contact only oneregulatory body responsible for all

regulation-related aspects, a so-called "One-Stop Shop"

there is no majority for- the US paradigm of a less rigid regulatory framework, especially regarding

product requirements, and stronger product liabilities

- a substitution of governmental regulations by self-regulation an adequate regulatory frameworkis not sufficient for the initial introduction

of new products and services world-wide in the sense of a lead market, but itmay help to increase the acceptance of consumers for novelties in Europe.

Regarding the differencesbetween sectors, we find that the food and pharmaceu-

tical companies suffer more from the burdens of the regulatory systems. The

answers of the research institutes are similar to those of the companies, but are less

sceptical regarding the impact of the regulatory framework on their R&D activities.

Based on open telephone interviews, other stakeholders, e.g. consumers, express

the following views:

Consumer organisations are in favour of regulations which secure the safetyand quality of products and argue that regulations are effective in providingincentives for companiesto develop products of higher quality and safety.

Trade unions favour in general a regulatory framework which protects the in-terests of the workforce, especially innovations reducing risks for health and

safety, but they are also very interested in framework conditions which promote

the innovative capacity of the respective industries.

Besides the different views of the stakeholders, significant differences between

sectors can be observed:

Within sectors characterised by strong public interest regarding the protectionof health, safety and the environment, the regulatory framework is more ex-tensive and rigid. Consequently, the companies in the pharmaceutical or food

industrybearhigher regulatory costs.

The conflicts between the representatives of the protected objects, like the con-sumer associations or environmental groups, and industry are stronger, because

more protection and less riskon the one side leads to more costs and less re-

sources for innovation on the other side.

In contrast, environmental technologies are promoted broadly by more rigidregulations, because both their suppliers and the environmental groups win

in the form of increasing market shares and betterenvironmental quality.


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Case studies in the pharmaceutical, the food and the environmental sector and

on standards complement the general analyses of frameworks and stakeholders.

1. The Impact of Regulation on the Development of New Products in the

Pharmaceutical Sector

The pharmaceutical industry is characterised by high investments in R&D and

innovation. In addition, the sector is highly regulated because of impacts of me-

dicinal products on health and safety of the consumers. Consequently, the relation-

ship between regulation and innovation in this sector deserves special attention.

However, the analysis of the impact of the regulatory framework on shaping (new)

markets in the pharmaceutical sector does notprovide a clear picture of the rela-

tions and causalities between the regulatory framework and innovative activities,like research and development and the marketing of new products.

The comparison of the general regulatory frameworkrelevant for the pharmaceu-

tical sector in the EU and the USA/Canada shows that the significant differences

of the past have been reduced to some minor discrepancies in detailed regulations.

In Europe, the creation of the EMEA (European Agency for the Evaluation of

Medicinal Products) and the centralised authorisation procedure were major steps

to overcome hindrances caused by conflicting national approval policies.

The companies in the pharmaceutical sector are interested in getting developeddrugs to the market as soon as possible and developing new or improved drugs

for new indication fields or diseases which cannot be treated so far. In contrast, the

rationality of the approval authorities in the pharmaceutical sector is to maximise

safety, in the extreme case by blocking beneficial products even with minimal risks.

Although significant progress has been made towards more efficient and faster

approval procedures, the pharmaceutical industry both in Europe and in the USA

still complains about the costly, uncertain and long approval procedures from first

research to the marketing of new pharmaceutical products discouraging research.

Specific policies for medicinal products have to be mentioned which are related to

rare diseases (the so-called "orphans") for which the costs of R&D and marketing

activities would not be recovered by the expected sales. Therefore, the pharmaceu-

tical industry is rarely interested to develop medicinal products for such diseases. In

order to ensure patients suffering from orphan diseases the same treatment as other

patients, specific regulations were established to stimulate R&D and market intro-

duction of respective medicinal products. Both in the USA and in the EU the intro-

duction of the Orphan Drug regulation had a strong positive impetus for R&D

activities and the market approvals for such products, but it is argued that the lack

of competition leads to too high prices for orphan drugs.


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2. The Impact of Regulation on the Development of New Products in the

Food Industry

In contrast to the pharmaceutical industry, the food industry is less R&D-

intensive. While in the past innovation in the food industry strongly depended on

technical developments in their supplying industries, current innovation activities

are mainly demand-oriented, which results in a high number of new or modified

products. We observe also in the food sector an increasing harmonisation of the

regulatory framework. However, in many innovative fields relevant for the food

industry the framework conditions in the EU often do not keep pace with scien-

tific and technical discoveries ortrends on the demand side.

In particular in interdisciplinary-oriented innovation fields of the food industry, e.g.

Functional Food to prevent nutrition-related diseases, the institutional and admin-

istrative framework impede innovation activities, since different competent authori-

ties are responsible for implementation, administration and control of regulations.

Since the mid 1990s, genetically modified (GM) plants have been cultivated

which can enter the food chain. In addition, genetic engineering approaches are re-

garded by their protagonists as major tools to increase productivity and efficiency in

food processing in future. On the other hand, an intensive public debate world-

wide concerns the safety of these approaches and derived novel foods, theirhealth

and environmental impacts as well as their wider socio-economic impacts. In

contrast to the USA policy ofnot requiringmarket approval for GM (geneticallymodified) crops, the EU approach for environmental release and market approval

of GMOs (genetically modified organisms) follows a ratherstrict interpretation of

the "precautionary principle". Therefore specific regulations have been put into

force which require often more complex procedures than for conventional products.

In 2001 the Directive 2001/18/EC modified the rules for environmental release and

market approval of GMOs significantly, by restricting market approval to ten years

and the requirement of post-market monitoring of each GMO, meaning a de facto

moratorium on the commercialisation of GMOs.

The definition of standards and the creation of labelling and control procedures fororganic food products does not seem to be sufficient for an early and fast take-off

on the supply side. The high technical and market-related risks impede farmers

from converting conventional farms to organic agriculture. Therefore, financial in-

centives seem to be an adequate instrument to speed up the adoption of new pro-

duction processes and products.

These three case studies, i.e. Functional Food, GMOs and organic food products,

underline the importance of regulations for the development of new markets in the

food sector. Unclear competencies and regulations or very restrictive market ap-

proval procedures impede new products or even the establishment of new markets.


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3. The Impact of Regulation on the Development of New Technologies in

the Environmental Sector

Environmental problems are one of the most prominent cases forexternal costs and

justify therefore environmental regulation. Thus, since the late 1960s, environ-

mental regulation has been a major political issue in all industrialised countries. In

almost every country, regulation takes mainly the form ofcommand and control

policies. However, there seems to be a move toward market-based instruments

recently in the form of emission taxes or tradable certificates.

The increase in environmental regulation in the 1970s to 1980s was caused in the

USA and Europe by an increasing public awareness in several fields of environ-

mental protection. General environmental regulations applicable to all areas of envi-

ronmental protection have been passed since the late 1980s concerning environ-

mental impact assessment, environmental liability, or the availability of environ-

mental information. In general, the introduction ofnew and stricter environmental

regulations has worked towards an increase in environmental innovations.

The water sector is a sector with rather conventional environmental technolo-

gies. Therefore at wastewater treatment plants, mostly incremental innovations take

place along an existing technological paradigm. In Europe and the USA the foun-

dations of the environmental regulation in the water sector were developed in the

1970s and made stricter in the 1980s. The technological development was influ-

enced by environmental regulations, not only by command and control policies,but also by emission charges on wastewater. Furthermore, long-term policy goals

were also very important, providing guidance for the development of water protec-

tion technologies.

Wind power is a new technological paradigm competing with conventional elec-

tricity generation. European countries, e.g. Denmark and Germany, and the USA

used R&D policies to trigger innovation in the early phase. However, only in Den-

mark and Germany did the R&D policy evolve constantly. In addition, the predict-

ability of fixed feed-in tariffs used in Germany, Spain and Denmark stimulated

market growth more than the subsidy and quota systems, e.g. in the USA. The mar-ket expansion in the European countries led to virtuous circles which made Europe

a lead market and its producers the key players in wind turbine supply.

The general overview and the case studies underlined that various aspects proved to

be very influential in deciding on the innovative effects of environmental regula-

tion: the existence and performance of general economic regulation, the institutional

processes which determine the interaction between R&D institutions, suppliers of

technology and users to create knowledge spillovers, or the existence of long-term

policy goals such as water quality or the doubling of renewable electricity supply.


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4. The Role of Standards for Shaping New Markets

Regarding the role of different types of standards for new technologies and markets,

the main results are the following. First, finding a common compatibilityand in-terface standard allows to build up critical masses which are a necessary condi-

tion for the emergence of network technologies, like the GSM standard in mobile

telecommunication. Furthermore, compatibility between existing and new tech-

nologies avoids the lock-in in old technologies, but increases also the attractiveness

of new technologies. Minimum safety and quality standards reduce transaction

costs and protect especially early adopters from risks, which increases the accep-

tance of, and the confidence in, new products and services. Information standards

have the same impact and allow consumers to assess the benefits of new products

more easily and better. In total, all kinds of standards play an important role for the

development of new markets, although compatibility and interface standards have aspecial relevance for the crucial network industries, like telecommunication.

Future Challenges for Regulatory Policy Shaping New Markets

All the different approaches to identify and analyse the role of regulation for shap-

ing markets for new products and services have shown various challenges, problems

and shortcomings:

The variety of regulations have different and often ambivalent impacts onthe introduction of new products and services

There is a significant lack of awareness regarding the issue of new productsand services within the regulatory bodies

The various interest groups and stakeholders involved in the regulatory processare also often not aware of the opportunities new products and services can

have for their own interests

The implementation of regulations is crucial for the incentives of companiesto develop and market new products and services.

Based on these general insights, we present four sets of proposals for regulatory

policies shaping new markets.

1. The General Role of Innovation for Regulatory Policy

Regulatory bodies responsible e.g. for the protection of competition, health andsafety or the environment, have to adequately consider the opportunities of

new products and services and innovation in general for achieving their tradi-

tional goals

Also the major stakeholders in regulation, except industry, have to checksys-tematically the positive influence of new products and services on their or-

ganisations objectives.


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2. Approaches to Increase the Quality of the Regulatory Framework

regarding Innovation

Regulatory bodies have to react more proactively to trends in science andtechnology relevant for their regulatory framework by:

- intensifying the contact to the science and technology community- implementing "regulatory foresight" exercises- observing on-going standardisation processes

The co-ordination and the division of work between standardisation andregulation activities have to become more efficient

The extent ofself-regulation has to take into account the trade-off between thegains in flexibility and the loss in legitimacy and acceptance among

stakeholders

Regulatory bodies have to focus on those types of regulations or shape regula-tions in a way which maximises the positive and minimises the negative impacts

for the development and market introduction of new products and services

The impact assessment approach of the European Commission already takesnew products and services into account but needs to be specified and to be ac-

companied by methodologically advanced impact assessment tools

The performance criteria of regulatory bodies have also to integrate indicatorsmeasuring the promotion of new products and services in balance with their

other objectives.

3. Coordination of Policies of Regulatory Bodies to Foster Innovation

Since innovation is a complex process, the promotion of innovation by regula-tory policies requires a comprehensive approach, co-ordinating or even inte-

grating the regulatory policies of all the regulatory bodies, e.g. it is not suffi-

cient to set a favourable framework for research, it is also necessary to stabilise

the demand for new products and services

Shaping the regulatory framework for new products and services should alsotake into account windows of opportunities to establish lead markets, i.e. com-

bination of favourable supply and demand conditions, which may generate trade

advantages and are therefore a source of future growth.

4. Improved Implementation of Regulations to Foster Innovation

The implementation of regulations has to be harmonised in order to reduce therisk and the costs of companies introducing new products and services

Approval times have to be reduced, since they are very negative for the ex-pected return of investment in long-lasting and expensive R&D resulting in in-

novative products and services

The transition ofregulatory bodies into service providers for the general pub-lic, but also for companies, represents a promising strategy also to promote their

general support for the introduction of new products and services.


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1. Introduction

The question of regulation, innovation and their impact on competitiveness inglobal markets has been discussed for decades, but is still of high relevance. For

example, at the World Economic Forum 2004 in Davos, one major issue is regula-

tion with innovation in mind. However, little has been done to understand the effect

of regulation on the capacity of European industry to develop new technologies and

to introduce new products and services to the market. The debate has taken place at

the level of anecdotal evidence and poor systematic empirical foundations. In addi-

tion, most of the approaches assume a static framework, not recognising the long-

term dynamic feedback loops between regulation and technical progress and new

markets. Finally, the majority of the expressed statements, especially from industry,

come to the conclusion that the negative impacts of regulation outweigh the positiveeffects.

The study "New Products and Services. Analysis of Regulations Shaping New

Markets" aims to bridge the gap between the challenge to shape a regulatory

framework, which allows the emergence of new markets, and even to use regulation

as an instrument to foster innovation on the one hand, and to reduce the lack of ade-

quate, reliable and systematic knowledge on their interrelationship, by applying a

methodological approach which considers the complexity and interdependence of

the multiple parameters and stakeholders. Regulation can vary between private self-

regulation of the involved stakeholders and governmental mandatory regulation.This variety will be taken into account, as well as the interfaces of regulation to

other spheres of public frameworks, like competition law. The optimal solution, that

means achieving an adequate balance between an environment fostering the intro-

duction of new products and services and securing consumer safety and environ-

mental protection, depends on several aspects, like the respective technologies in-

volved and products or services supplied.

The report contains six chapters. The second chapter presents a conceptual frame-

work of the relationship between regulation and innovation. In the third chapter, we

review regulatory systems relevant for new markets applying a revised taxonomy of product market regulations. Then we give an overview of those European regula-

tions, which are relevant for innovation and the market introduction of new prod-

ucts, followed by a review of regulatory reform in the network industries in the

Member States and recent regulatory reforms in the USA, Canada and Japan with

an impact on innovation. We conclude the chapter with an overview of the priorities

of institutions responsible for regulation in Europe, the USA and Japan. In chapter

four the views of stakeholders on the relation between regulation and innovation are

presented. First, the results of a survey focussing on European companies in se-

lected sectors are presented. In addition to the views of companies, we show also

the results of a survey among research institutes asking about the impact of the


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regulatory framework on their R&D activities and of interviews with other

stakeholders like consumer associations. In chapter five, we present the results of

three in-depth case studies covering the pharmaceutical, the food and the environ-

mental sector and selected technical standards. In addition selected success storiesof technical standards shaping new markets are displayed. The concludes with an

outlook how in future the innovation dimension can be better integrated into regu-

latory policies.


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2. A Conceptual Framework to Analyse the Relationship

Between Innovation and Regulation

2.1 Introduction

This introductory chapter aims to provide a conceptual framework for the analysis

of the general relationship between regulation and innovation, especially focusing

on the impact of the regulatory framework on the development and diffusion of new

products and the emergence of new markets.1 Since there is no comprehensive theo-

retical framework for the regulation-innovation relationship, we must rely on the

very few studies which have also focused, besides other aspects, on the issue we

address in this report. This chapter tries to organise the partial insights drawn from

various contributions in order to construct a concept which allows us to analyse therelationship between regulation and innovation in a systematic way.

Except for some specific topics (Intellectual Property Rights) and for some specific

sectors (environmental regulations), very few studies have been performed which

explicitly focus on the link between regulation and new or modified products and

services or innovation aspects in general. Often, these insights are by-products of

broader studies, mostly on competitiveness of specific industries or national

economies. This observation should not be explained by the restricted relevance of

the issue, but by its high complexity and the difficulty to comprehend it in a simple

framework. This difficulty is caused both by the complexity of the regulatoryframework, which is many-sided and has various often contradictory impacts,

and the complexity of the innovation process, which is not just linear from basic

research to market introduction of new products and services, but interactive with

multiple feedback loops and involves many actors and institutions, linked through

numerous and different relationships. Consequently, one of the major results of the

literature is to underline that it is impossible to draw any simple and general conclu-

sions about the link between regulation and new products and markets. It cannot be

postulated that a specific regulatory measure will lead inevitably to more innova-

tion, since there are many subtle variations within each category of regulations.

Moreover, most regulatory requirements generate contradictory effects on innova-

tion, being both positive to certain phases or actors in the innovation process and

negative regarding other phases or economic actors.

This two-sided complexity calls for the development of an adequate analytical

framework, which can be applied and tested for various sectors and regulatory

frameworks. This would allow us to gather stylised facts to reach a better under-

standing of the relationship. One essential reason for the difficulty to establish a link

1 This chapter draws significantly on Brousseau (1998) and the literature cited there.


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between the two phenomena is, indeed, the lack of specific, dedicated studies on the

topic. In order to remedy this lack, a systematic assessment of the impact of various

dimensions of regulations on the diverse aspects of the innovation process is

needed. It would enable the gathering of the necessary information to build an ade-quate analytical framework to help to develop public policies aimed to encourage

innovation in form of new products and services or even new markets.

In order to reach this aim, the chapter is structured as follows. First, the variety of

regulations and the complexity of the innovation process will be outlined in order

both to clarify the concepts and to derive some methodological insights. Then, the

most important conclusions about the causal links between regulation and innova-

tion will be presented.

2.2 Types of Regulation

The term regulation generally refers to the implementation of rules by public

authorities and governmental bodies to influence market activity and the behaviour

of private actors in the economy. Such intervention in the market is justified by the

goal to maximise collective welfare, including reaching some distributive goals. In

economic literature and by the OECD (1997), three types of regulatory interven-

tions are usually distinguished.

2.2.1 Economic Regulation

This type of regulation refers to public interventions to remedy market or competi-

tion failures. The basic assumption behind this concept is that competitive markets

are the best way to achieve economic efficiency in the tradition of neo-classical

economic theory. However, markets sometimes do not work efficiently, because:

the market mechanism generates inefficient adaptation processes, market equilibria are not stable, competition destroys competition leading to monopolies, competitive markets (many suppliers) are less efficient than non-competitive

ones (few suppliers).

These different reasons lead to a certain degree of public or governmental interven-

tion, even in very liberal economies, in order to ensure efficient performance of

markets. We can differentiate between the following two types of economic regula-

tion.


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Pro-competitive or Antitrust Regulations

Pro-competitive or antitrust regulations aim to avoid impediments for competitive

markets by competition itself. This type of regulation is mostly directed at the su- pervision of firms' behaviour, like mergers and acquisitions, pricing policies, gen-

eral selling conditions, relationship between suppliers and consumers, and to the

repression of anti-competitive ones. It must be pointed out that sometimes this type

of regulation induces public authorities paradoxically to erect barriers to entry or to

reduce the competitive intensity.

Regulation of Natural Monopolies and Public Utilities

In traditional economic literature, it is generally considered that in some sectors

with specific cost structures in the production process, a single producer a mo-nopoly is the most efficient solution, because economies of scale or because some

strategic resources, like military equipment or energy suppliers, deserve to be ex-

cepted from the principle of competition. In those markets, public authorities try to

avoid a rationing of the markets and rent capturing by monopolistic behaviour like

overstated prices. Public authorities can therefore legitimately restrict and supervise

private or independent operators.

2.2.2 Social Regulation

Social regulation refers to public intervention necessary to correct externalities in

general. Externalities arise when economic agents do not fully bear or appropriate

the consequences of their actions because market mechanisms are missing or just

not possible. Due to physical or institutional constraints, like the non-existence of

property rights on certain resources, many economic activities have side effects.

These side effects or externalities cause a difference between the private and social

cost and benefit of actions, like the production and distribution of goods, that results

in a misallocation of resources. Two types of regulations are appropriate for effects

caused by externalities.

Internalisation of Externalities

The internalisation of externalities tries to provide an incentive scheme that induces

economic decision-makers to make the best decision according to the collective

interest. Whether the internalisation of externalities is inspired by the Pigovian tra-

dition based on taxes or subsidies (in case of positive side effects) or by the Coasian

paradigm based on an appropriate definition of property rights and private negotia-

tion, the aim of this regulation is to lead economic agents, producers and consumers

to fully bear the consequences of their decisions and actions. It includes the protec-


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tion of the environment (Kemp 1998), public health, and protection of buyers from

risky, poor or defective goods and services. Public policies are generally more con-

cerned with negative than with positive externalities, since the former cause gener-

ally more damage for social welfare than the latter. However, since positive exter-nalities are characterised by the same feature of an incorrect incentive structure,

public authorities can correct them in order to generate an increase of social wel-

fare, for example by subsidising the production of non-marketable goods which

generate positive externalities or by public procurement schemes, which favour new

technologies with less negative impacts on the environment.

The Provision of Public Goods

Collective or public goods represent a special case of extreme externalities which

are not divisible among consumers (Samuelson 1954). For pure collective or publicgoods, it is not possible to exclude any individual after it is produced (non-

excludability) and its use by additional consumers does not reduce the consumption

or welfare of the other, already consuming agents (non-rivalry in consumption).

Since the production of a public good by an individual agent makes it at least

theoretically available for all the members of a society who cannot even be forced

to pay for it, public goods are extreme cases of externalities. Therefore, they gener-

ate serious free-riding problems and market mechanisms fail to cause sufficient

incentives for their private production. Consequently, public authorities are often

either directly involved in their production or they commission a private company

with its production and charge all members of the society with mandatory fees,mostly in form of taxes.

2.2.3 Administrative or Market-organising Regulations

In the tradition of institutional economics, public authorities are not only responsi-

ble for a most efficient performance of existing markets, but also for the general

organisation of markets.2 More precisely, they or even other non-governmental

public institutions have to enable private agents to use resources and to transfer

them among each other. Collective governance devices and inter-individual agree-ments both influence the design and implementation of resource usage rights and

ensure their transfer among economic agents (North 1990, Williamson 1985). Eco-

nomic agents must spend resources to define the boundaries of the resources they

use and to exclude unauthorised parties from access to these resources. When these

resources are transferred from one agent to another, the transferred user's rights

have to be specified and the transfer has to be made effective according to the trans-

2 The OECD classification defines a third type of regulation as administrative regulation (OECD

1997). Some of these, especially those with relevance for innovation, belong to market-

organising regulations.


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fer agreements. The effectiveness and the efficiency of the institutional framework

influences the costs of using and transferring resources for the individual. There-

fore, the institutional framework is one of the major factors for the efficiency both

in a static and in a dynamic sense of the economic system.

Consequently, many rules issued by governmental bodies as well as by organisa-

tions responsible for their implementation are instruments through which public

authorities can influence economic efficiency. This is especially the case for the

legal framework dedicated to the organisation of property rights and the boundaries

of contractual practices. These allow markets to emerge and to work. However, the

assessment of legal rules can only take place if their implementation also is ac-

knowledged, which is in the responsibility of implementing institutions.

2.3 The Assessment of the Impact of Regulation on

Innovation

The impact of regulation on innovation is difficult to assess, because most assess-

ments perform an evaluation based on static efficiency criteria, although innovation

is intrinsically a dynamic process. Furthermore, innovation is a complex phenome-

non and it is difficult grasp all of its sometimes contradictory aspects.

In this study we focus on product innovations, following the OECD definition of the"Oslo Manual", covering both goods and services introduced to the market which

are either new or significantly improved with respect to fundmental characteristics.

However, often process innovations in the form of new or significantly improved

technology are crucial for the production or the supply of new goods and services.

Therefore, we restrict ourselves not only to product, but take also into account rele-

vant process innovations. Innovation in general should be based on the results of

new technological developments, new combinations of existing technology or utili-

sation of other knowledge by firms.

The assessment of regulation is mostly based on static efficiency criteria instead ofdynamic ones, since the latter approach would require long-term observations of the

behaviour of the affected economic agents. Economic regulations are judged on the

basis of the generated improvement of social welfare estimated by changes of pro-

duction costs, prices, and turnover. The efficiency of social regulation is estimated

on the basis of the remaining level of externality, e.g. environmental pollution, or of

the volume (and costs) of available resources. Finally, the efficiency of administra-

tive regulations in the sense of institutional and legal framework conditions is as-

sessed through the level of the so-called "transaction costs", which often cannot be

directly measured but only by proxies.


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Besides the methodological shortcomings, it has to be stated that assessments of

economic regulations are often reduced to the analysis of theoretical models without

a direct application to concrete regulatory changes. An exception is the regulatory

impact assessment programme of the United States of America (OECD 1999). Fur-thermore, innovation is a phenomenon which is difficult to grasp. In general, the

impact of regulation can be measured either by the input or the output of the inno-

vation process.

Innovation also requires physical and human resources like a production process. It

is performed in a first stage by formal processes of R&D and by informal and

sometimes unintentional processes of learning-by-doing or learning-by-interacting.

In order to generate economic effects, the results of the R&D process have to be

adapted to the needs of potential users and have to be promoted by marketing ac-

tivities. As a consequence for the analysis, the inputs into the innovation processcannot be reduced just to R&D expenditures. Especially in the service sector, new

services are generated by a close interaction between the consumers and the service

providers, whereas R&D activities are of minor importance. Finally, innovation

processes are characterised by a high level of uncertainty, which makes it difficult

to identify a close link or causality between inputs into the innovation process and

its final result.

The measurement of innovation by output has to take into account that it can take

place at the level of new products, new services or even new markets, but may in-

clude also process innovations like the application of new technologies and organ-isational innovations caused by changes in the management. Some of these aspects

can be more easily observed than others, but often they are interconnected. Fur-

thermore, radical innovations can be observed better than incremental innovations

which are characterised by gradual changes of products, processes or organisations.

However, the latter type of innovation is much more frequent than the first, more

spectacular type. A final problem for the observation of process or organisational

innovations, which are not so relevant for this study, is the fact that they are often

kept private and not disclosed by a product announcement or a patent application.

Summarising the characteristics of the output of innovation, it is easier to observe

completely new products and services than improved processes or organisationalchanges.

In addition, studies about the impact of regulation on innovation should take into

account how regulations affect the various aspects of the complex process of inno-

vation. Since innovation is a process of search, discovery, development, improve-

ment, and adoption of new products and processes, it is also a cumulative process,

that produces an increasing amount of knowledge.

This has consequences for the analysis of the impact of regulation, which cannot be

based on a simple linear and mechanistic stimulus-response model, since this does


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not take into account the complex interdependencies between regulatory policy

measures and the manifold aspects of innovation:

First, since an innovative process requires the co-ordination of very diverse op-erations, its efficiency is influenced by the dynamic articulation of these varioustasks as much as by the individual performance. It must therefore be pointed out

how regulations affect the ability of economic agents to articulate these tasks

within and among firms, and finally how it impacts on the speed of the innova-

tion process, as well as on its quality in terms of the fitness of the results to the

needs of the users and of the appropriability by producers.

Since an innovation process leads not only to new products or processes, but alsoto knowledge, it is essential to determine how regulation affects the production

and diffusion of knowledge.

Third, innovation implies the co-ordination of various parties within and amongfirms, the impact of regulation on this co-ordination including inter-firm collabo-

ration has to be taken into account.

Fourth, since innovation is a dynamic process, the causal relationship betweenregulation and innovation may change over time. Therefore, the assessment of

the impact of regulation has to acknowledge its various impacts on the diverse

phases of an innovation process.

2.3.1 The Impact of Economic Regulation on Innovation

Most of the existing literature on this issue is dedicated to the analysis of the impact

of antitrust regulation on innovation. Recently, the approaches have become more

differentiated and go beyond simple monopoly regulation towards more efficient

incentive regulation, also taking into account stimulating effects on innovation.

In general, it has to be underlined that the effect of economic regulation on innova-

tion is very controversial. Therefore, one cannot analyse the relationship on an ab-

stract level, but must investigate concrete variants of regulation. Nevertheless,

regulatory constraints generate contradictory effects for innovation. It is central to

take into account that a very pro-competitive regulation scheme forces companies to

innovate in order to reach a competitive advantage. However, this scheme may for-

bid strategies and organisational arrangements, like close collaborations between

firms, which are necessary to introduce new technologies and new products into the

market successfully. However, if the regulatory regime tries to protect infant indus-

tries and firms in order to develop new markets, then the consequence could be the

persistence of a protected industry, which will not become competitive with foreign,

unprotected industries.


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These two examples make clear that it is necessary to analyse the impact of the

various types of economic regulation on the various aspects of innovation and inno-

vative processes.

Antitrust or Pro-competition Regulation

The link between pro-competitive regulation and innovation has been discussed

since Schumpeter's seminal contributions. Four issues have to be taken into account.

First, regulation and innovation mutually affect each other. Second, there are two

very contradictory positions about the impact of regulation on innovation. Third,

this antagonism is mainly caused by a divergent understanding of competition that

leads to very contrasting implementations of pro-competition or antitrust regulation.

It is generally accepted that not only does regulation influence innovation, but thatinnovation also has an impact on regulation, since in many industries the so-called

de-regulation or liberalisation processes have been induced by technological inno-

vations. The best example is the telecommunications industry, which was formerly

a natural monopoly, but triggered by technological change (e.g. digitalisation of

transmission) into an industry with "normal" production cost structures. Therefore,

the regulatory framework adequate for a natural monopoly had to be adapted to the

new situation caused by technological innovations. We have observed not only in

telecommunications, but also in other industries that the technological development

drove the evolution of regulation towards highly pro-competitive regulation.

The other way round, it is confirmed that pro-competitive policies affect the likeli-

hood to innovate. De-regulation of markets leads in most cases to a price decrease.

Reduced prices force companies either to make production processes more efficient

by searching for new innovative technologies, or companies have to introduce new

products into the markets, which may be superior to the existing one. Consequently,

de-regulation often allows formerly regulated companies to expand their product

and service assortment by the introduction of new products and services.

There are two antagonistic views about the impact of regulation on innovation. On

the one hand, pro-competitive frameworks are supposed to be favourable to innova-tion. Since companies are allowed to choose their strategies and actions without

restrictions, innovation activities should be easier to perform. In addition, in a

highly competitive environment, firms are strongly forced to innovate, because both

product and process innovations allow them to survive in the long run by being

ahead of the competitors. In a Schumpeterian perspective, innovating firms enjoy a

temporary monopoly that provides them with rents. In sum, competitive environ-

ments caused by pro-competitive regulations are positive for innovation.

However, the empirical evidence is rather ambivalent, not only for methodological

reasons, but because it is based on theoretical approaches, which assume that inno-


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vation requires both the close co-operation between firms and significant resources.

On the contrary, pro-competitive policies reduce the ability of firms to form strong

alliances, especially in the R&D stage. In addition, innovation is costly and leads to

temporary inefficient resource allocation. Only in the long run can the broad distri-bution of new products or the broad application of new technology make it possible

to recover the investments in the early stages. Consequently, innovation processes

should deserve some kind of protection in their infancy stage, which is realised by

patent protection. However, protection does not necessarily mean a direct public

intervention, but only that innovators should be able to protect their innovation as

they want, including the formation of strong company alliances often the target of

antitrust investigations. Besides this liberal approach, evolutionary economists even

plead for a direct protection of industries and innovators in their infancy by subsi-

dising R&D, erecting barriers to entry or admitting some anti-competitive practices,

including mergers leading to high market concentration. In total, all these trains ofthought postulate that pro-competitive regulation damages innovation.

The explanation for these two antagonistic views is based on differences regarding

the understanding of competition. Based on neo-classical economics, markets

should be competitive in the sense that as many firms as possible should supply a

market with their goods. This excludes a supplier structure with only a few or just

even one dominant firm a monopolist. Consequently, regulatory bodies have to

prohibit an integration between firms via mergers and acquisitions, which leads to a

high level of concentration and just a very small number of suppliers inclined to

adopt monopolistic behaviour, like price increases or little innovation activities. Orif markets are dominated by very large firms, regulatory bodies have to break them

down into many small firms.

From a dynamic point of view, competition is a selection process that in the long

run selects the most efficient techniques, commercial strategies and organisations.

During this selection process, firms with dominant, even monopolistic positions can

emerge. This is not a problem from the dynamic efficiency criteria, as long as these

positions are contestable by new entrants (Baumol et al. 1982). This entry threat

leads the dominant firms to be efficient and not to exercise monopoly power. Con-

sequently, dominant positions have not to be forbidden, but their abuses.

In relation to innovation, pro-competitive policies have to take into account that in

their infancy innovation processes are not efficient and "competitive", but they are

necessary to ensure competition in the long run. As a consequence, during the for-

mation phase of a technological or product life cycle, while companies build up new

capacities, pro-competition authorities should tolerate most firm practices including

cross-subsidisation, market restriction, and barriers to entry. In the long run, such

practices should be forbidden, since they enable firms to escape from competition,

leading to inefficient resource allocation, a slowdown of technical progress, a re-

duction of innovative activities and a rationing of consumers.


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Monopoly and Public Utilities Regulation

Under the regulatory framework in the 1960s and 1970s, monopolies and public

utilities had no strong or biased incentives to innovate. Therefore in the 1980s, theUnited States started to implement regulations in order to motivate them to make

productivity gains and realise innovations. However, these new regulatory princi-

ples reduced the rents of the regulated firms they formerly captured and often used

for large R&D projects and other innovation activities. Therefore, an incentive-

financing dilemma emerged for some public utilities.

Especially network-based services, like telecommunications, water and energy sup-

ply, were regulated under the old regulation principles, which consisted either in

rate of return regulation or pricing at marginal costs. Under the rate of return regu-

lation, the monopoly should reach a profitability not higher than the average firm inindustry. Under marginal cost pricing, the monopoly was forced to price its prod-

ucts according to two-part tariffs (Ramsey-Pricing).

In relation to innovation, these regulatory schemes were responsible for the low or

biased technical progress towards capital intensive production (Averch-Johnson

Effect) and little innovation in some of the regulated industries, like telecommuni-

cation and the energy sector. Based on the progress of the economics of information

(Stiglitz 1975), appropriate incentive schemes have been developed to overcome the

information asymmetries between regulated companies and regulatory bodies. This

led to the implementation of new regulatory schemes based on the idea that there isa "revealation-incentives" dilemma that can be solved by a fine tuning via "price

cap" regulation. Price cap regulations are based on contracts between the regulator

and the regulated firm, which require minimum quality and fixed maximum prices.

If productivity gains can be appropriated at least partly by the regulated firm,

then this scheme causes incentives for innovation, especially in the direction of pro-

ductivity gains. If the regulatory body wants to capture all productivity gains, the

regulated firms have no incentive to innovate. The same is true if the regulatory

framework tries to implement a competition, which allows multiple suppliers with

inefficient cost structures in their production. Consequently, they try to increase

their market shares by price competition, which reduces their profits and does notallow them to invest in R&D and innovation.3

3 The high competitive pressure among the deregulated electric utilities led to the recent energy

shortage in the USA, due to too little investment in new power plants.


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2.3.2 The Impact of Social Regulation on Innovation

The impact of social regulations on innovations is not as often analysed as the im-

pact of economic regulations. However, it is also less controversial.Most of the existing literature on social regulations and their impact on innovation

is focused on the analysis of the impact of environmental regulation caused by the

increasing importance of environmental issues (Kemp 1998). In addition, new envi-

ronmental regulations have discarded existing machinery and equipment and en-

abled new entrants to introduce new production techniques in industry. Environ-

mental regulations have caused the emergence of new industries, as in the case of

the "environmental industry" and of new products with less or almost no negative

impacts on the environment. The counter-hypothesis postulates that environmental

regulations restrict the firms in their innovative activities and cause additional costs,

which have a negative impact on their competitiveness and consequently also ontheir capability to innovate. It is consensus that the regulation of end-of-pipe tech-

nologies has these negative effects, whereas the regulation of integrated environ-

mental protection may be ambivalent for innovation. Kemp (1998) introduces a

further dimension of the relationship and proposes to use regulation as a modulator

of technical change, i.e. social regulation may change the direction of technical

change into innovations with less negative impacts on the environment.

In empirical studies, Jaffe et al. (1995) find no support either for the conventional

wisdom that environmental regulations have large adverse effects on competitive-

ness or that they stimulate innovations.

In sectors with strong ethical dimensions and a high importance of externalities as

in the matter of health, the activities and strategies of the involved actors are so

bound by regulations, that the link between regulation and innovation is obvious

and close. Safety regulations may on the one hand prohibit innovations, if the public

authorities forbid presumably risky products. On the other hand, safety regulations

increase the acceptance of new products and services among consumers, since they

can rely on some minimum product safety. However, especially the health sector is

affected by various other means of intervention (Day et al. 1993). Consequently, the

perspective has to be broadened from the single regulation to the institutions that

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New products and services: Analysis of regulation shaping new markets